Core Econ Unit 1

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1THE CAPITALISTREVOLUTION

HOW CAPITALISM REVOLUTIONISED THE WAY WE LIVE, ANDHOW ECONOMICS ATTEMPTS TO UNDERSTAND THIS AND OTHERECONOMIC SYSTEMS• There have been dramatic changes in living standards in different countries in the last

1,000 years

• In many countries these living standards began to rise rapidly at the time of thecapitalist revolution

• Advances in technology and a distinctive economic system contributed to thisrevolution

• Economics is the study of how people interact with each other, and with the naturalenvironment, in producing their livelihoods

• Capitalism is an economic system in which private property, markets and firms play a

major role• The rise in living standards has been accompanied by changes in population and the

way people live, by environmental impacts, and by changes in inequality betweencountries and within countries

• There is great variation across countries in their success in raising incomes, and in thedegree of inequality in living standards within them

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See www.core-econ.org for the full interactive version of The Economy by The CORE Project.Guide yourself through key concepts with clickable figures, test your understanding with multiple choice

questions, look up key terms in the glossary, read full mathematical derivations in the Leibniz supplements,watch economists explain their work in Economists in Action – and much more.

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core econ | Curriculum Open-access Resources in Economics2

In the 14th century the Moroccan scholar Ib’n Battuta (see box) described Bengalin India as “a country of great extent, and one in which rice is extremely abundant.Indeed, I have seen no region of the earth in which provisions are so plentiful.” Andhe had seen much of the world, having travelled to China, west Africa, the MiddleEast and Europe. Three centuries later, the same sentiment was expressed by the 17thcentury French diamond merchant Jean Baptiste Tavernier who wrote of the country:

“Even in the smallest villages, rice, flour, butter, milk, beans and other vegetables, sugar andsweetmeats, dry and liquid, can be procured in abundance…”– Jean Baptiste Tavernier, Travels in India (1676)

At the time of Ib’n Battuta’s travels Indiawas not richer than the other parts of theworld. But India was not much poorer,either. An observer at the time wouldhave noticed that people, on average, werebetter off in Italy, China and England thanin Japan or India. But the vast differencesbetween the rich and the poor, which thetraveller would have noted wherever hewent, were much more striking than thesedifferences across regions. Rich and poorwould often have different titles: in someplaces they would be feudal lords andserfs, in others royalty and their subjects,slave owners and slaves, or merchants andthe sailors who transported their goods.Then—as now—your prospects dependedon where your parents were on theeconomic ladder and whether you weremale or female. The difference in the 14thcentury, compared with today, was thatthen it mattered much less in which partof the world you were born.

Fast forward to today. The people ofIndia are far better off than they wereseven centuries ago if we think abouttheir access to food, medical care, shelterand the necessities of life; but by worldstandards today most are poor.

Figure 1.1a tells some of the story (you canfollow links from the figure to the sources of the data). The height of each line is anestimate of average living standards—using a measure called gross domestic productper capita , which we will explain in the next section—at the date on the horizontalaxis.

IB’N BATTUTA

Ib’n Battuta (1304-1368) was aMoroccan traveller and merchantwhose travels were published in hisbook Rihla (The Journey). His travels,lasting 30 years, took him across northand west Africa, eastern Europe, theMiddle East, south and central Asia

and China. He travelled more than70,000 miles (113,000km); muchfurther than the distance covered byhis better-known contemporary, MarcoPolo (1254-1324).

IB'N BATTUTA


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UNIT 1| THE CAPITALIST REVOLUTION 3

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Figure 1.1a History’s hockey stick: Gross domestic product per capita in five countries (1000- 2013).

Source: Bolt, Jutta, and Jan Juiten van Zanden. 2013. ‘The First Update of the Maddison Project Re-EstimatingGrowth Before 1820.’ Maddison-Project Working Paper WP-4. Broadberry, Stephen. 2013. ‘Accounting for theGreat Divergence.’ London School of Economics and Political Science. November 1.

On average people in the UK are six times better off than in India by this measure. Japanese people are as rich as the British, just as they were in the 14th century, butnow Americans are even better off than the Japanese, and Norwegians are better offstill.

We can draw the graph in Figure 1.1a because of the work of Angus Maddison whodedicated his working life to finding the scarce data to make useful comparisonsof how people lived across more than 1,000 years (his work is continuing in theMaddison Project). In this course you will see that data like this about regions of theworld, and the people in it, is the starting point of all economics: in this video, Nobellaureate James Heckman and Thomas Piketty explain how collecting data has beenfundamental to their work on inequality and the policies to reduce it. We will studytheir work in Unit 19.

So 1,000 years ago the world was flat, economically speaking. There were differencesin income between the regions of the world; but as you can see from Figure 1.1a, thedifferences were small compared to what was to follow.


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1.1 HISTORY’S HOCKEY STICK: GROWTH IN INCOME

A different way of looking at the same data in Figure 1.1a is to use a scale that showsGDP per capita doubling as we move up the vertical axis (from $250 per capita peryear to $500, then to $1,000, and so on). This is called a ratio scale and is shown inFigure 1.1b. The ordinary scale is useful for comparing the levels of GDP per capitaacross countries, but the ratio scale is best for comparing growth rates acrosscountries.

By the growth rate of GDP or of any other quantity like population, we mean the rateof change:

growth rate = change in GDPoriginal level of GDP

If the level of GDP per capita in the year 2000 is $21,046, as it was in Britain in thedata shown in Figure 1.1a, and $21,567 in 2001, then we can calculate the growth rate:

growth rate = change in GDPoriginal level of GDP

y2001 – y2000 y2000=

21,157 – 21,406

21,406=

= 0.025

= 2.5%

Whether we want to compare levels or growth rates depends on the question weare asking. Figure 1.1a makes it easy to compare the levels of GDP per capita acrosscountries, and at different times in history. Figure 1.1b uses a ratio scale, whichmakes it possible to compare growth rates across countries and at different periods.When a ratio scale is used, a series that grows at a constant rate looks like a straightline. This is because the percentage (or proportional growth rate) is constant. Asteeper line in the ratio scale chart means a faster growth rate.

To see this, think of a growth rate of 100%: that means the level doubles. In Figure1.1b, with the ratio scale, you can check that if GDP per capita doubled over 100 yearsfrom a level of $500 to $1,000, the line would have the same slope as a doubling from$2,000 to $4,000 dollars, or from $16,000 to $32,000 over 100 years. If, instead ofdoubling, the level quadrupled (from say, $500 to $2,000 over 100 years), the linewould be twice as steep, reflecting a growth rate that was twice as high.


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Interact

Follow figures click-by-click in the full interactive version at www.core-econ.org .

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Figure 1.1b History’s hockey stick: Living standards in five countries (1000-2013) using theratio scale.

Source: Bolt, Jutta, and Jan Juiten van Zanden. 2013. ‘The First Update of the Maddison Project Re-EstimatingGrowth Before 1820.’ Maddison-Project Working Paper WP-4. Broadberry, Stephen. 2013. ‘Accounting for theGreat Divergence.’ London School of Economics and Political Science. November 1.

History’s hockey stick

There were cultural changes and scientific advances in many parts of the world overthe entire period shown in the figure, but living standards began to rise in a sustainedway only from the 18th century. The figure looks like a hockey stick, and our eyes aredrawn to the kink. The hockey-stick kink is less abrupt in Britain, where growth beganaround 1650. In Japan the kink is more defined, occurring around 1870. The kink inChina did not happen until around 1980, and in India even more recently. GDP percapita actually fell in India during British colonial rule. You can see that this is also trueof China during the same period, when European nations dominated China’s politicsand economics. The ratio scale makes it possible to see that recent growth rates in

Japan and China were higher than elsewhere.

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If you have never have seen an ice-hockey stick (or ice hockey), this is why we callthese figures hockey stick curves:

In some economies, substantial improvements in people’s living standards did notoccur until they gained independence from colonial rule or interference by Europeannations:

• When 300 years of British rule of India ended in 1947, according to Angus Deaton,

an economist: “It is possible that the deprivation in childhood of Indians… was assevere as that of any large group in history”. In the closing years of British rule, achild born in India could expect to live for 27 years. Fifty years on, life expectancyat birth in India had risen to 65 years.

• China had once been richer than Britain, but by the middle of the 20th centuryGDP per capita in China was one-fifteenth that of Britain.

• Neither Spanish rule of Latin America, nor its aftermath following theindependence of most Latin American nations early in the 19th century sawanything resembling the hockey-stick upturn in living standards experienced bythe countries in Figures 1.1a and 1.1b.

We learn two things from Figures 1.1a and 1.1b:

• For a very long time living standards did not grow in any sustained way.• When sustained growth occurred it happened at different times in different

countries, leading to vast differences between living standards around the world.

Understanding how this occurred has been among the most important questions thateconomists have asked, starting with the founder of the field, Adam Smith, who gavehis most important book the title An Inquiry into the Nature and Causes of the Wealth ofNations .


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ADAM SMITH

Adam Smith (1723-1790), considered by manyto be the father of economics, was raised byhis widowed mother in Scotland. He studiedphilosophy at the University of Glasgow and laterat Oxford, where he wrote: “the greater part ofthe… professors have… given up altogether eventhe pretence of teaching.”

He travelled throughout Europe, visiting Toulouse,France where because he had “very little to do”,

he said, he had “begun to write a book in order topass away the time.” It became the most famousbook in economics.

In An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776,Smith asked: how can society coordinate the independent activities of large numbersof economic actors—producers, transporters, sellers, consumers—often unknownto each other and widely scattered across the world? His radical claim was thatcoordination among all of these actors might spontaneously arise, without any personor institution consciously attempting to create or maintain it. This challenged previous

notions of political and economic organisation, in which rulers imposed order on theirsubjects.

Even more radical was his idea that this could take place as a result of individualspursuing their self interest: “It is not from the benevolence of the butcher, the brewer,or the baker that we expect our dinner, but from their regard to their own interest,” hewrote, adding that each would be “led by an invisible hand to promote an end whichwas no part of his intention.”

Since then this “invisible hand” has been a metaphor for how markets can coordinate

the self-interested pursuits of people to produce a socially desirable outcome.

Smith did not think that people were guided entirely by self-interest, and he wrotea book about ethical behaviour called The Theory of Moral Sentiments, published in1759.

He also understood that the market system had some failings, especially if sellers onmarkets banded together so as to avoid competing with each other. “People in thesame trade seldom meet together,” he wrote, “even for merriment and diversion, butthe conversation ends in a conspiracy against the public; or in some contrivance to

raise prices.”

GREAT ECONOMISTS


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DISCUSS 1.1: THE ADVANTAGES OF CONVENTIONAL AND RATIO SCALES

Figure 1.1a used a conventional scale for the vertical axis, and Figure 1.1b used aratio scale.

1. Choose any two of the countries shown in these figures and compare theirgrowth from 1400 to the present, using the information in the figures.

2. Which figure is more helpful for this comparison and why?

1.2 MEASURING INCOME AND LIVING STANDARDS

The estimate of living standards, GDP per capita , that we used in Figures 1.1a and 1.1bis a measure of total income (and output) in a country (called gross domestic product ,or GDP), which is then divided by the country’s population.

GDP is a measure of the total output of the economy in a given period, such as a year:Diane Coyle, an economist, says it “adds up everything from nails to toothbrushes,tractors, shoes, haircuts, management consultancy, street cleaning, yoga teaching,plates, bandages, books, and the millions of other services and products in theeconomy”.

He specifically targeted monopolies that were protected by governments, such as theBritish East India Company that not only controlled trade between India and Britain,but also administered much of the British colony there.

He agreed with his contemporaries that government should protect the nation fromexternal enemies and ensure justice through the police and the court system—he alsoadvocated government investment in education, and in public works such as bridges,roads, and canals.


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Adding up these millions of services and products requires finding some measureof how much a yoga class is worth compared to a toothbrush. Economists must firstdecide what should be included, but also how to give a value to each of these things.In practice, the easiest way to do this is by using their prices.

Three important points to remember about measuring average living standards in acountry:

• GDP is a measure of total income in a country; to get an average measure, GDP isdivided by population, giving GDP per capita.

• GDP per capita is not the same as the disposable income of a typical person.• A person’s disposable income is a measure of his or her living standards, but it

omits important aspects of wellbeing.

What do the second and third points mean? A person’s living standard refers to howwell off the person is. This is sometimes measured by an individual’s disposableincome. This is the amount of wages or salaries, profit, rent, interest and transferpayments from the government (such as unemployment or disability benefit) orfrom others (for example, gifts) received over a given period such as a year, minusany transfers the individual made to others including taxes paid to the government.Disposable income is thought to be a good measure of living standards because it isthe maximum amount of food, housing, clothing and other goods and services thatthe person can buy without having to borrow—that is, without going into debt orselling possessions. But, if your disposable income was used to represent your livingstandard, you might question this for two reasons:

• Is our disposable income a good measure of our wellbeing?• When we’re part of a group of people (a nation for example, or an ethnic group) is

the average disposable income a good measure of how well off the group is?

Disposable income and wellbeing

Income is a major influence on wellbeing because it allows us to buy the goods andservices that we need or enjoy. But it is insufficient, because many aspects of ourwellbeing are not related to what we can buy. For example, disposable income leavesout:

• The quality of our social and physical environment such as friendships and cleanair.

• Goods and services that we do not buy, such as healthcare and education if theyare provided by a government.

• Goods and services that are produced within the household, such as meals orchildcare (predominantly provided by women).


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Average disposable income and average wellbeing

Consider a group of people in which each person initially has a disposable incomeof $5,000 a month, and imagine that, with no change in prices, income has risen forevery individual in the group. Then we would say that average or typical wellbeing

had risen.But now think about a different comparison. In a second group, the monthlydisposable income of half the people is $10,000. The other half has just $500 tospend every month. The average income in the second group ($5,250) is higher thanin the first (which was $5,000 before incomes rose). But would we say that the secondgroup’s wellbeing is greater than that of the first group, where everyone has $5,000 amonth? The additional income in the second group is unlikely to matter much to therich people, but the poor half would think their poverty was a serious deprivation.

Absolute income matters for wellbeing, but we also know from research that peoplecare about their relative position in the income distribution. They report lowerwellbeing if they find they earn less than others in their group.

Since income distribution affects wellbeing, and because the same average incomemay result from very different distributions of income between rich and poor withina group, average income may fail to reflect how well off a group of people is bycomparison to some other group.

Valuing government goods and services

GDP includes the goods and services produced by the government, such as schooling,national defence, and law enforcement. They contribute to wellbeing but are notincluded in disposable income. In this respect, GDP per capita is a better measure ofliving standards than disposable income.

But government services are difficult to value, even more difficult to value thanservices such as haircuts and yoga lessons. For goods and services that people buywe take their price as a rough measure of their value (if you valued the haircut lessthan its price, you would have just let your hair grow). But the goods and servicesproduced by government are typically not sold, and the only measure of their value tous is how much it cost to produce them.

The gaps between what we mean by wellbeing, and what GDP per capita measures,should make us cautious about the literal use of GDP per capita to measure how welloff people are. But when the changes over time or differences among countries inthis indicator are as great as those in Figures 1.1a and 1.1b (and in Figures 1.9 and1.10 later in this unit), GDP per capita is undoubtedly telling us something about thedifferences in the availability of goods and services.

We look in more detail at how GDP is calculated so that we can compare it throughtime, and make comparisons between countries, in this unit’s Einstein section(many of the units have Einstein sections: they will show you how to calculate many


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of the statistics that we use). Using these methods, we can use GDP per capita tounambiguously communicate such ideas as “people today in Japan are on averagea lot richer than they were 200 years ago, and a lot richer than the people of Indiatoday.”

Looking at the two parts of Figure 1.1, the obvious next question is: what changed sodramatically in the past 300 years?

DISCUSS 1.2: WHAT SHOULD WE MEASURE?

While campaigning for the US presidency on 18 March 1968, Senator Robert Kennedygave a famous speech questioning “the mere accumulation of material things” in

American society, and why, among other things, air pollution, cigarette advertisingand jails were counted when the US measured its living standards, but health,education or devotion to your country were not. He argued that: “It measureseverything, in short, except that which makes life worthwhile.”

Read his speech in full, or listen to a sound recording of it.

3. In the full text, which goods does he list as being included in a measure of GDP?4. Do you think these should be included in such a measure, and why?5. Which goods does he list in the full text as missing from the measure?6. Do you think they should be included, and why?

1.3 THE PERMANENT TECHNOLOGICAL REVOLUTION

Remarkable scientific and technological advances occurred more or less at thesame time as the upward kink in the hockey stick in Britain in the middle of the18th century. Important new technologies were introduced in textiles, energyand transportation. Its cumulative character led to it being called the IndustrialRevolution .


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As late as 1800, traditional craft-based techniques, using skills that had been handeddown from one generation to the next, were still used in most production processes.The new era brought new ideas, new discoveries, new methods and new machines,making old ideas and old tools obsolete. These new ways were, in turn, made obsoleteby even newer ones.

Although in everyday usage, technology refers to machinery, equipment and devicesdeveloped using scientific knowledge, in economics, technology is a processthat takes a set of materials and other inputs—including the work of people andmachines—and creates an output. For example, a technology for making a cake canbe described by the recipe that specifies the combination of inputs (ingredients suchas flour, and labour activities such as stirring) needed to create the output (the cake).Another technology for making cakes uses large-scale machinery, ingredients andlabour (machine operators).

Until the Industrial Revolution, the economy’s technology, like the skills needed tofollow its recipes, was updated only slowly and passed from generation to generation.As technological progress revolutionised production, the time required to make apair of shoes fell by half in only a few decades; the same was true of spinning andweaving, and of making cakes in a factory. This marked the beginning of a permanenttechnological revolution because the amount of time required for producing mostproducts fell generation after generation.

Technological change in lighting

To get some idea of the unprecedented pace of change, consider the way we producelight. For most of human history technological progress in lighting was slow. Ourdistant ancestors typically had nothing brighter than a campfire at night. The recipefor producing light (had it existed) would have said: gather lots of firewood, borrowa lighting stick from some other place where a fire is maintained, and start andmaintain a fire.

The first great technological breakthrough in lighting came 40,000 years ago, withthe use of lamps that burned animal or vegetable oils. We measure technologicalprogress in lighting by how many units of brightness called lumens could be

generated by an hour of work. One lumen is approximately the amount of brightnessin a square metre of moonlight. One lumen-hour (lm-hr) is this amount of brightnesslasting an hour. For example, creating light by a campfire took about 1 hour of labourto produce 17 lm-hr, but animal fat lamps produced 20 lm-hr for the same amount ofwork. In Babylonian times (1750 BC) the invention of an improved lamp using sesameoil meant that an hour of labour produced 24 lm-hr. Technological progress was slow:this modest improvement took 7,000 years.

Three millennia later, in the early 1800s, the most efficient forms of lighting (usingtallow candles) provided about nine times as much light for an hour of labour as

had the animal fat lamps of the past. Since then lighting has become more and moreefficient with the development of town gas lamps, kerosene lamps, filament bulbs,


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fluorescent bulbs and other forms of lighting. Compact fluorescent bulbs introducedin 1992 are about 45,000 times more efficient, in terms of labour time expended,than lights were 200 years ago. Today the productivity of labour in producing light ishalf a million times greater than it was among our ancestors around their campfire.

Figure 1.2, below, charts this remarkable hockey-stick growth in efficiency in lightingusing the ratio scale we introduced in Figure 1.1b.

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Source: Nordhaus, William. 1998. ‘Do Real Output and Real Wage Measures Capture Reality? The History ofLighting Suggests Not.’ Cowles Foundation For Research in Economics Paper 957.

The process of innovation did not end with the Industrial Revolution as the case oflabour productivity in lighting shows. It has continued with the application of newtechnologies in many industries, such as the steam engine, electricity, transportation(canals, railroads, automobiles), and most recently, the revolution in informationprocessing and communication. These broadly applicable technological innovationsgive a particularly strong impetus to growth in living standards because they changethe way large parts of the economy work.

By reducing the amount of work time it takes to produce the things we need,technological changes allowed significant increases in living standards. DavidLandes, an economic historian, wrote that the Industrial Revolution was “aninterrelated succession of technological changes” that transformed the societiesin which these changes took place. This process continues today: Hans Rosling, astatistician, claims, in this video of a TED lecture, that we should say “thank you


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industrialisation” for creating the washing machine, a labour-saving device thathad a far-reaching effect on the wellbeing of millions of women, including his ownmother.

1.4 A CONNECTED WORLD

In July 2012 the Korean hit Gangnam Style wasreleased. By the end of 2012 it had been the best-selling song in 33 countries, including Australia,

Russia, Canada, France, Spain and the UK. With 2billion views by the middle of 2014, Gangnam Stylealso became the most watched video on YouTube.The permanent technological revolution hasproduced a connected world.

Everyone is part of it. The materials making up thisintroduction to economics were written by teams ofeconomists, designers, programmers and editors,working together—often simultaneously—at computers in the UK, India, the US,

Russia, Colombia, South Africa, Chile, Turkey, France and many other countries. Ifyou are online, some of the transmission of information occurs at close to the speedof light. While most of the commodities traded around the globe still move at thepace of an ocean freighter, about 21 miles (33km) per hour, international financialtransactions are implemented in less time than it took you to read this sentence.

The speed at which information travels provides more evidence of the novelty of thepermanent technological revolution. By comparing the known date of a historicalevent with the date at which the event was first noted in other locations (in diaries, journals or newspapers) we can determine the speed at which news travelled. When

Abraham Lincoln was elected US President in 1860, for example, the word was spreadby telegraph from Washington to Fort Kearny, which was at the western end of thetelegraph line. From there the news was carried by a relay of riders on horsebackcalled the Pony Express, covering 1,260 miles (2,030km) to Fort Churchill in Nevada,from where it was transmitted to California by telegraph. The process took seven daysand 17 hours. Over the Pony Express segment of the route, the news travelled at 7miles (11km) per hour. A half-ounce (14 gram) letter carried over this route cost $5, orthe equivalent of five days’ wages.

From similar calculations we know that news travelled between ancient Rome and

Egypt at about 1 mile (1.6km) per hour, and 1,500 years later between Venice andother cities around the Mediterranean it was, if anything, slightly slower. But, a few

Gagnam Style


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centuries later, as Figure 1.3 shows, the pace began to quicken. It took “only” 46 daysfor the news of a mutiny of Indian troops against British rule in 1857 to reach London,and readers of the Times of London knew of Lincoln’s assassination only 13 days afterthe event. One year after Lincoln’s death a transatlantic cable cut the time for news totravel between New York and London to a matter of minutes.

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2.7 MPH: News of battle of Trafalgar, offcoast of Spain, reaches London(1805)

Figure 1.3 The speed at which information travelled (1000 to 1865).

Source: Tables 15.2 and 15.3 from Clark, Gregory. 2007. A Farewell to Alms: A Brief Economic History of theWorld. Princeton, NJ: Princeton University Press.

1.5 THE GROWTH OF POPULATION AND CITIES

Alongside technological progress and a rising standard of living, population hasgrown rapidly. For most of the last 12,000 years the population of the world grewslowly, if at all, with increases in good years followed by declines in response toclimatic adversity and other disasters.

Figure 1.4 shows the evolution of world population from the year 1000 onwards.In a few countries, population started to grow rapidly 200 years ago, but theworld’s population took off in the 20th century with the development and spreadof improved sewerage, clean water, and other public health measures. While the

number of people in the world continues to grow, as shown in Figure 1.4, the paceof growth is slowing from its peak in the 1970s (see Figure 1.5). The demographic


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transition refers to the slowdown in population growth as the fall in death ratesis balanced by a fall in birth rates associated with the desire for fewer children,combined with public policies discouraging larger families, as in China.

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Figure 1.4 World population (1000-2010).

Source: Maddison, Angus. 2015. ‘Statistics on World Population, GDP and Per Capita GDP, 1-2008 AD.’ Accessed June 2015, and US Census Bureau. 2015. ‘International Programs, International Data Base.’ Accessed June 2015.

With the increased productivity oflabour in agriculture, fewer farmerswere required to feed the nonfarmingpopulation. Higher labour productivitymeans that on a given piece of land,more output could be produced by eachfarmer. People left farming to pursue

other occupations, resulting in anotherchange: the growth of cities. Threehundred years ago, the vast majorityof people lived in the countrysideinteracting with just a handful ofpeople, mostly family and neighbours.In the last few centuries, however,people have been drawn—or, in somecases, pushed—into cities.

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Figure 1.5 How the world’s population growthin the 20th century rose and fell.

Source: Angus Maddison historical statistics. USCensus: World population growth rate.


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DISCUSS 1.3: WORLD POPULATION DATA

Click on the source of Figure 1.4 and then on the link called “statistics on worldpopulation”. This will automatically download an Excel file to your computer with,among other data, the data used to plot Figure 1.4 (this is the second worksheet inthe Excel file).

Scroll down to the rows showing China and India and add up these numbers to showa total population for China and India for each year.

1. Plot this total population in a graph similar to Figure 1.4. Now insert the totalpopulation for the 30 Western European countries into the same graph. What canyou say about population growth in these two groups of countries over time?

2. Finally, use this data to plot the ratio scale version of this graph (refer to thedescription of a ratio scale in Section 1.1). Compare the population growth rateof these two groups of countries using your new graph. Can you explain thedifferences in the growth rates?

3. What are the implications of the differences in (2)?

City living is a drastic change, as everyday life is populated by dozens or evenhundreds of strangers. This of course changes how we interact with others—many ofwhom we will never see again—in some cases challenging people’s personal securityand requiring new ways of maintaining social order. Police forces are a relatively newfeature of human society, dating from the emergence of large urban areas.

In 1850 there were only three cities with populations exceeding 1 million people—London, Paris, and Beijing—but, as Figure 1.6 demonstrates, by 2013 there were morethan 500 cities of this size.

Tokyo, the world’s biggest urban area, ishome to 34 million people. That’s four timesas many people living in one city today asarchaeologists think existed in the entireworld 11,000 years ago, at the time humansfirst took up farming. In 1900, nine of the 10largest cities in the world were in Europe orNorth America—Tokyo was the exception.Today nine of the 10 are in Asia or LatinAmerica, with New York the odd one out.

Tokyo: Birds-eye view


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Figure 1.6 Cities with more than 1 million inhabitants (2013).

Source: ‘Major Agglomerations of the World - Population Statistics and Maps.’ 2015. Accessed June 2015. Datais for agglomerations (a central city and neighbouring towns (suburbs) forming a connected region of dense, predominately urban population wi th more than 1 million inhabitants.

1.6 IMPACTS ON THE ENVIRONMENT

As production has soared (Figures 1.1a and 1.1b, and also Figure 1.2), so too haveboth the use of our natural resources and degradation of our natural environment.Elements of the ecological system such as air, water, soil, and weather have beenaltered by humans more radically than at any time in human history.

One example is climate change. Figures 1.7a and 1.7b present evidence that ouruse of fossil fuels—coal, oil, and gasoline—have profoundly affected the naturalenvironment. After having remained relatively unchanged for many centuries,increasing emissions of carbon dioxide (CO 2) into the air during the 20th centuryhave resulted in measurably larger amounts of CO 2 in the earth’s atmosphere (Figure1.7a) and brought about perceptible increases in the northern hemisphere’s averagetemperatures (Figure 1.7b). Figure 1.7a also shows that CO 2 emissions from fossil fuelconsumption have risen dramatically over the past 250 years.


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DISCUSS 1.4: THE ENVIRONMENTAL KUZNETS CURVE

Many researchers think that there is a hump-shaped relationship between acountry’s income and environmental degradation. This relationship is often referredto as the Environmental Kuznets Curve (EKC).

1. Read this description of the EKC and, in your own words, explain why such arelationship might be observed.

2. How might this relationship change when we define income as GDP versus GDPper capita?

Figure 1.7b shows that the average temperature of the earth fluctuates from decadeto decade. Many factors cause these fluctuations, including volcanic events such asthe Mount Tambora eruption in Indonesia, in 1815. Mount Tambora spewed so muchash that the Earth’s temperature was reduced, and 1816 became known as the “yearwithout a summer”.

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Atmospheric CO 2

Global Carbon emissionsfrom fossil fuel burning

Figure 1.7a Carbon dioxide in the atmosphere (1010-2010) and global carbon emissionsfrom burning fossil fuel (1750-2010).

Source: Years 1010-1975: Etheridge, D. E., L. P. Steele, R. J. Francey, and R. L. Langenfelds. 2012. ‘HistoricalRecord from the Law Dome DE08, DE08-2, and DSS Ice Cores.’ Division of Atmospheric Research, CSIRO, Aspendale, Victoria, Australia. Years 1976-2010: Data from Mauna Loa observatory. Boden, T. A., G. Marland,and R. J. Andres. 2010. ‘Global, Regional and National Fossil-Fuel CO2 Emissions.’ Carbon Dioxide Information Analysis Center (CDIAC) Datasets.

http://faculty.georgetown.edu/aml6/pdfs&zips/PalgraveEKC.pdfhttp://faculty.georgetown.edu/aml6/pdfs&zips/PalgraveEKC.pdf


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In the last century, average temperatures have risen in response to increasingly highlevels of greenhouse gas concentrations. These have resulted from the CO2 emissionsassociated with the burning of fossil fuels. The likely consequences of globalwarming are far-reaching: melting of the polar ice caps, rising sea levels that may putlarge coastal areas under water, and potential changes in climate and rain patternsthat may destroy the world’s food-growing areas.

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Figure 1.7b Northern hemisphere temperature over the long run (1000-2006).

Source: Mann, M. E., Z. Zhang, M. K. Hughes, R. S. Bradley, S. K. Miller, S. Rutherford, and F. Ni. 2008. ‘Proxy-Based Reconstructions of Hemispheric and Global Surface Temperature Variations over the Past Two Millennia.’Proceedings of the National Academy of Sciences 105 (36): 13252–57.

Climate change is a global development. But many environmental impacts arelocal, as residents of cities suffer respiratory and other illnesses as a result of highlevels of harmful emissions from power plants, vehicles, and other sources. Ruralcommunities, too, are impacted by deforestation and the depletion of the supply ofclean water and fishing stocks.

These examples of the way that people affectand are affected by both local and globalecologies motivate the way that we use the

word “economy”. When we named our ebookThe Economy we were thinking about the waythat people interact with each other, and alsowith nature, in producing their livelihood.

Figure 1.8 shows one way of thinking about theeconomy: the economy is part of a larger socialsystem, which is itself part of the biosphere,which is the collection of all forms of life onearth.

BIOSPHERE

SOCIETY

ECONOMY

Figure 1.8 The economy is part of society, which is part of the biosphere.


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From global climate change to local resource exhaustion, these effects are results ofboth the expansion of the economy (illustrated by the growth in total output) and theway the economy is organised (what kinds of things are valued and conserved, forexample).

There is no doubt that the permanent technological revolution—which broughtabout dependence on fossil fuels—is part of today’s environmental problem. But it isalso part of the solution.

Look back at Figure 1.2, which showed the productivity of labour in producing light.The vast increases shown over the course of history and especially since the mid 19thcentury occurred in large part because the amount of light produced per unit of heat(for example from a campfire, candle, or light bulb) increased dramatically.

In lighting, the permanent technological revolution brought us more light for lessheat, which conserved natural resources—from firewood to fossil fuels—used ingenerating the heat. Advances in technology today may allow greater reliance onwind, solar and other renewable sources of energy.

CLIMATE CHANGE

The human causes, and the reality, of climate change are no longer widely

disputed in the scientific community.

The Intergovernmental Panel on Climate Change is the authoritative source forresearch and data. The likely consequences of global warming are far-reaching:melting of the polar ice caps, rising sea levels that may put large coastal areasunder water, and potential changes in climate and rain patterns that maydestroy the world’s food-growing areas. The long-term physical and economicconsequences of these changes, and the appropriate policies that governmentscould adopt as a result, are discussed in detail in Unit 18.

1.7 CAPITALISM DEFINED

Looking back over the data in Figures 1.1 to 1.7 we see an upward turn, like the kink in

our hockey stick, repeated for:


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• Gross domestic product per capita• Productivity of labour (light per hour of work)• Connectivity of the various parts of the world (the speed at which news travels)• World population

• Impact of the economy on the global environment (Carbon emissions,atmospheric CO 2 and climate change)

How can we explain the change from a world in which living conditions fluctuatedif there was an epidemic or a war, to a situation in which most of the time eachgeneration is noticeably, and predictably, better off than the previous one?

The answer that makes most sense both factually and logically is what we call thecapitalist revolution, which introduced a new economic system called capitalism characterised by a new combination of institutions . An economic system is a way

of organising the production and distribution of goods and services in an entireeconomy. And by institutions, we mean the different sets of laws and social customsregulating production and distribution in different ways in families, privatebusinesses, and government bodies.

In some economies in the past the keyeconomic institutions were private property,markets and families, because productionusually took place in families rather than firms.Think about a farm owned by a family: who

does the work? Who consumes the produce?This has historically been determined bythe older generation of the family (in mostsocieties, the older men), and by social custom.

In other societies the government has been theinstitution governing production, distributionand the process of change. In this case,

most production has taken place in government-owned establishments, and thegovernment has decided how the goods that were produced were used, including who

gets what. This is called a centrally planned economic system. It existed, for example,in the Soviet Union, East Germany and many other eastern European countries priorto the end of Communist Party rule in the early 1990s.

Though governments and families are essential parts of the workings of everyeconomy, most economies today are capitalist. Since most of us live in capitalisteconomies, it is easy to overlook the importance of institutions that are fundamentalfor capitalism to work well: they are so familiar, we hardly ever notice them. Beforeseeing how private property, markets and firms combine in the capitalist economicsystem, we need to define them.

CAPITALISM

An economic system inwhich three key institutions

play an important role:

• Private property• Markets• Firms


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1.8 PRIVATE PROPERTY, MARKETS AND FIRMS

Over the course of human history the extent ofprivate property has varied. In some societies,such as the hunters and gatherers who areour distant ancestors, almost nothing exceptpersonal ornaments and clothing was ownedby individuals. In others, crops and animalswere private property, but land was not. Theright to use the land was granted to families byconsensus among members of a group, or by

a chief, without allowing the family to sell theplot.

In other economic systems other humanbeings—slaves—were private property.

In a capitalist economy, an important form ofprivate property is made up of the equipment,buildings, raw materials, patents and otherintellectual property, and other inputs used in

producing goods and services. These are calledcapital goods .

In a capitalist economy, private property does not include some essentials suchas the air we breathe and most of the knowledge we use (such as our skills, ourknowledge of how to produce things, and our capacities to solve problems that arisein production). Private property may be ownedby an individual, a family, a business, or someentity other than the government.

Think of all the ways that goods and servicesmay be transferred from one person to another:as a gift, by theft, by a government order.Markets differ from these, and other ways thatgoods or services may be transferred from oneperson to another, in two respects:

• They are reciprocated : First, unlike gifts andtheft, in a market one person’s transferof a good or service to another is directly

PRIVATE PROPERTY

Private property means thatyou can:

• Enjoy your possessionsin a way that you choose

• Exclude others fromtheir use if you wish

• Dispose of them bygift or sale to someoneelse...

• ... who becomes theirowner

MARKETS

Markets are:

• A way of connectingpeople who mutuallybenefit

• By exchanging goodsand services

• Through a process ofbuying and selling


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reciprocated by a transfer in the other direction (either of another good or serviceas takes place in barter exchange, or money, or a promise for a later transfer whenone buys on credit).

• They are voluntary : Both transfers—by the buyer and the seller—are voluntarybecause the things being exchanged are private property. So the exchange mustbe beneficial in the opinion of both parties. In this, markets differ from theft, andalso from the transfers of goods and services in a centrally planned economy.

DISCUSS 1.5: THE POOREST MAN’S COTTAGE

“The poorest man may in his cottage bid defiance to all the forces of the Crown. It maybe frail, its roof may shake; the wind may blow through it; the storms may enter, therain may enter—but the King of England cannot enter; all his forces dare not cross thethreshold of the ruined tenement.” William Pitt, 1st Earl of Chatham, speech in the British Parliament (1763)

1. What does this tell us about the meaning of private property?2. Does it apply to people’s homes in your country?

DISCUSS 1.6: MARKETS AND SOCIAL NETWORKS

Think about a social networking site that you use, for example Facebook. Now lookat our definition of a market.

What are the similarities and differences between the social networking site and amarket?

But private property and markets alone do not define capitalism. In many places theyhad been important institutions long before capitalism. The most recent of the threecomponents making up the capitalist economy is the firm.

The kinds of firms that make up a capitalist economy include restaurants, banks,large farms that pay others to work there, industrial establishments, supermarkets,

internet service providers, and many more. Other productive organisations thatare not firms and which play a lesser role in a capitalist economy include family


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businesses, in which most or all of thepeople working are family members,non-profit organisations, employee-owned cooperatives, and government-owned entities (such as railways andpower or water companies). These arenot firms, either because they do notmake a profit, or because the ownersare not private individuals who own theassets of the firm and employ others towork there. Note: a firm pays wages orsalaries to employees; but if it takes onunpaid student interns, it is still a firm.

Firms existed, playing a minor role,in many economies long before theybecame the predominant organisationsfor the production of goods andservices, as they are in a capitalisteconomy. This created a boom inanother kind of market that had playeda limited role in earlier economicsystems: the labour market . Theowners of the firms as employers (ortheir managers) offer jobs at wages orsalaries that are high enough to attractpeople who are looking for work.

In economic language, the employers are the demand side of the labour market (they“demand” employees), while the workers are the supply side , offering to work underthe direction of the owners and managers who hire them.

A striking characteristic of firms, that distinguishes them from families andgovernments, is how quickly they can be born, expand, contract and die. A successfulfirm can grow from just a few employees to a global company with hundreds ofthousands of customers, employing thousands of people, in a few years. Firms cando this because they are able to hire additional employees on the labour market,and attract funds to finance the purchase of the capital goods they need to expandproduction.

Firms can die in a few years too. This is because a firm that does not make profitswill not have enough money (and will not be able to borrow money) to continueemploying and producing. The firm shrinks, and some of the people who work therelose their jobs.

FIRM

Afirm is a way of organisingproduction with the followingcharacteristics:

• One or more individuals owna set of capital goods that areused in production

• They pay wages and salaries toemployees

• They direct the employees(through the managers they also

employ) in the production ofgoods and services• The goods and services are the

property of the owners• Who sell them on markets with

the intention of making a profit


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Contrast this with a successful family farm. The family will be better off than itsneighbours; but unless it turns the family farm into a firm, and employs other peopleto work on it, expansion will be limited. If, instead, the family is not very good atfarming, then it will simply be less well off than its neighbours. The family headcannot make his children redundant. As long as the family can feed itself there isno equivalent mechanism to a firm’s failure that will automatically put it out ofbusiness.

Government bodies tend to be more limited in their capacity to expand if successful,and are usually protected from failure if they perform poorly.

Markets and private property are essential parts of how firms function for tworeasons:

• Inputs and outputs are private property : The firm’s buildings, equipment, patents,and other inputs into production, as well as the resulting outputs, belong to theowners.

• Firms use markets to sell outputs : The owners’ profits depend on markets in whichcustomers may willingly purchase the products at a price that will more thancover their costs.

One way to remember the distinctiveness of the capitalist economic system isthat unlike other economic systems, one of its hallmarks is the private ownershipof capital goods that are organised for use in firms. Other economic systems aredistinctive because of the importance of privately owned land, the presence ofslaves, because the government owns capital goods, or because of the limited role offirms. Capitalist economies differ, too, from earlier economies in the magnitude ofthe capital goods used in production. Massive power looms have replaced spinningwheels; a tractor now pulls a plough to do a job once done by a farmer using a hoe.

1.9 CAPITALISM AS AN ECONOMIC SYSTEM

Figure 1.9 shows that the three parts of the definition of a capitalist economic systemare nested concepts. Private property is an essential condition for the operation ofmarkets, and the firm, in turn, presupposes markets and private property. The left-hand circle describes an economy of isolated families who own their capital goodsand the goods they produce, but have little or no exchange with others.


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An economic

system withprivate property

Market economy withfamily-based production

Capitalist economicsystem

Self-sufficient family-based production

and markets and firms

Figure 1.9 Capitalism: Private property, markets and firms.

Historically, economies like the left-hand circle have existed, but have been much lessimportant than a system in which markets and private property are combined (themiddle circle). In the middle circle most production takes place either by individuals(shoemakers or blacksmiths, for example) or in families (in our example, this was ona farm). Prior to 1600 a great many of the economies of the world were like this.

Capitalism is an economic system that combines decentralisation withcentralisation:

• Capitalism decentralises : It limits the powers of governments and of otherindividuals in the process of owning, buying and selling.

• Capitalism centralises : It concentrates power in the hands of owners and managersof firms who are then able to secure the cooperation of large numbers ofemployees in the production process.

An easy way to remember this contrast is that when the owner of a firm interactswith an employee, he or she is “the boss”. When the same owner interacts witha potential customer he or she is simply another person trying to make a sale, incompetition with other firms. It is this unusual combination of competition among

firms, and concentration of power and cooperation within them, that accounts forcapitalism’s success as an economic system.

How the institutions of capitalism—private property, markets, and firms—combinewith each other and with families, governments, and other institutions differsgreatly across countries. Just as ice and steam are both water, China and the US areboth capitalist economies. But they differ in the extent to which the governmentinfluences economic affairs, and in many other ways. As this demonstrates,definitions in the social sciences often cannot be as precise as they are in the naturalsciences.


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Learning a new language

We hope you will not only learn about the economy in this course but also learn todo economics, and this means learning to speak a new language. Using the terms ofeconomics helps us to communicate complicated ideas with others who have learned

the language. This is why we stress definitions.Being able to explain how economists use words is also crucial to communicatingwith other people about economics. For this reason, and because by now you haveseen a number of definitions, think about what a definition does for us.

Water, for example, is defined chemically as a compound of two hydrogen atomsbonded with one oxygen atom, which takes the liquid form but also a solid form (ice)and a gaseous form (steam), not to mention other forms (snow or fog). Some peoplemight say that “ice is not really water”, and object that the definition is not the “true

meaning” of the word.But debates about “true” meaning (especially referring to complex ideas likecapitalism, or democracy) misunderstand why definitions are valuable. Think of thedefinition of water, or of capitalism, not as capturing some true meaning—but ratheras a device that is valuable because it makes it easier to communicate.

The word “capitalism”, like “water”, refers not to a single thing, but to a class of thingssharing common characteristics. And, like the definition of water (which requiresthat we know how to use the words oxygen and hydrogen precisely), we needed to

define the three institutions making up the capitalist economic system before wecould define capitalism itself.

But unlike water, we cannot identify a capitalist economic system using easy-to-seephysical characteristics.

Britain was definitely capitalist in 1800 and definitely not capitalist in 1500, but itwould be pointless to try to find a precise date at which a switch occurred. For muchof the period of transition we would say that the economy was a mixed economicsystem with both capitalist and non-capitalist elements.

China was a centrally planned economy from 1953 until economic reforms began in1978. Afterwards it adopted new institutions so that markets, private property andfirms became important. Today it is a capitalist economy. But in which year, exactly,did the definition come to be justified?

Major distinctions are important—the difference between a centrally planned and acapitalist economy, for example—but we can admit that the boundary between oneand the other is rarely precise in real life, and so the way we describe a system willalways be subjective. Even today, although capitalism is dominant in China, there is

still a centrally organised Five Year Plan.


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DISCUSS 1.7: FIRM OR NOT?

Using our definition, explain whether each of the following entities is a firm bystating whether it satisfies the characteristics that define a firm . Research the entityonline if you are stuck.

1. John Lewis (UK)2. A family farm in Vietnam3. Your current family doctor’s office or practice4. Walmart (US)5. An 18th century pirate ship (see our description of The Rover in Unit 5)6. Google (US)7. Manchester United plc (UK)8. Wikipedia

1.10 CAPITALISM, CAUSATION AND HISTORY’S HOCKEY STICK

There are both historical and logical reasons for thinking that the emergence ofcapitalism as an economic system is one of the causes of the upward kink in thehockey sticks we have seen.

But we should be sceptical when anyone claims that something complex (capitalism)“causes” increased living standards (or technological improvement, population

growth, a networked world, or environmental challenges).In science, we support the statement that X causes Y by:

• Understanding the relationship between cause ( X) and effect ( Y )• Performing experiments to gather evidence by measuring X and Y

In physics, we have a good understanding of how heat changes the state of water(transforming some of it to steam, for example), and we can easily do an experimentto see what happens when we raise its temperature to 100C (you repeat this

experiment whenever you boil water). Therefore we can make a convincing causalstatement about what will happen when we raise the temperature of water.


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Equivalent causal statements are essential in economics. We would often like todevise ways of changing something so that the economy works better, and this meansmaking a causal statement that policy X is likely to cause change Y . For example, aneconomist might claim that: “If the central bank lowers the interest rate, more peoplewill buy homes and cars.”

But economics isn’t physics. We don’t fully understand the detailed causal processes,and we often can’t do experiments (though in Unit 4 we will give examples of theuse of conventional experiments in one area of economics). So how can economistsdo science? This example shows how the things we observe in the world can help usinvestigate causes and effects.

DO INSTITUTIONS MATTER FOR GROWTH IN INCOME?

We can observe that capitalism emerged at the same time as, or just before, boththe Industrial Revolution and the upward turn in our hockey sticks. This would beconsistent with the hypothesis that capitalist institutions were among the causesof the era of continuous productivity growth. But the emergence of a free-thinkingcultural environment known as the Enlightenment also predated or coincided with theupturn in the hockey sticks. So was it institutions, or culture, both, or some other setof causes? Economists and historians disagree, as you will see in Unit 2, when we ask“What were the causes of the Industrial Revolution?”

Scholars in all fields try to narrow the range of things on which they disagree byusing facts. For complicated economic questions, like “Do institutions mattereconomically?”, facts may provide enough information to reach a conclusion.

A method for doing this is called a natural experiment . It is a situation in which thereare differences in something of interest—a change in institutions for example—thatare not associated with differences in other possible causes. Because we cannotchange the past, even if it were practical to conduct controlled experiments on entirepopulations, we rely on natural experiments, as Jared Diamond, a biologist, andJames Robinson, a professor of government, explain.

The division of Germany at the end of the second world war into two separateeconomic systems—one centrally planned in the east, the other capitalist in the west—provides a natural experiment. The so-called Iron Curtain that divided them separatedtwo populations sharing the same language, culture, and recent history as capitalisteconomies.

Before the second world war, living standards in what later became East and WestGermany were the same. This is a suitable setting for using the natural experimentmethod. Before the war, firms in Saxony and Thuringia were world leaders in

HOW ECONOMISTS LEARN FROM FACTS


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automobile and aircraft production, chemicals, optical equipment and precisionengineering.

With the introduction of centralised planning in East Germany, private property,markets and firms virtually disappeared. Decisions about what to produce, howmuch and in which plants, offices, mines and farms were taken not by privateindividuals, but by government officials. The state officials managing these economicorganisations did not need to follow the principle of capitalism and produce goodsand services that customers would buy at a price above their cost.

West Germany remained a capitalist economy.

The East German Communist Party forecast in 1958 that material wellbeing wouldexceed the level of West Germany by 1961. The failure of this prediction was one of the

reasons the Berlin Wall separating East from West Germany was bui lt in 1961. By thetime the Berlin Wall fell in 1989, and East Germany abandoned central planning, itsGDP per capita was less than half of that of capitalist West Germany. Figure 1.10 showsthe different paths taken by these and two other economies from 1950. It uses theratio scale.

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l e :

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i n 1

9 9 0 U S $

Figure 1.10 The two Germanies: Planning and capitalism (1950-89) .

Source: The Conference Board. 2015. ‘Total Economy Database.’ Accessed June 2015. Maddison, Angus. 2001. ‘The World Economy: A Millennial Perspective.’ Development Centre Studies. Paris: OECD.


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When is capitalism dynamic?

Two sets of conditions contribute to the dynamism of the capitalist economic system.One set is economic; the other is political, and it concerns the government and the

way it functions.

Economic conditions

The impact of economic conditions is summarised by the contrast between thesecond and third columns in Figure 1.11. Capitalism is less dynamic when propertyrights are insecure, there is limited competition in markets, and when the leadershipof firms is in the hands of those who have not been tested by competition, but whoinstead have acquired their position via inheritance from parents or a politicalconnection.

PRIVATE PROPERTY

... AND WHEN IT ISN’TWHEN CAPITALISM IS DYNAMICCHARACTERISTICS OF

Secure Insecure

MARKETS Competitive (the losers lose) Monopolised (the losers survive)

FIRMS Leadership acquired by merit Leadership from connections or inheritance

Figure 1.11 Economic institutions that make capitalism dynamic.

Notice from Figure 1.10 that East Germany had a less good starting position than WestGermany in 1950. This was not mainly because of differences in the amount of capitalequipment or skills available per head of the population, but because the structure ofindustries in East Germany was more disrupted by splitting the country than was thecase in West Germany.

Unlike some capitalist economies that had lower per capita incomes in 1950, EastGermany did not catch up to the world leaders, which included West Germany. By1989, the Japanese economy (which had also suffered war damage) had, with its ownparticular combination of private property, markets and firms along with a stronggovernment coordinating role, caught up to West Germany, and Spain had c losed partof the gap.

We cannot conclude from the German natural experiment that capitalism alwayspromotes rapid economic growth while central planning is a recipe for stagnation.Instead what we can infer is more limited: during the second half of the 20th century,the divergence of economic institutions mattered for the livelihoods of the Germanpeople.


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When these institutions are functioning well so that private property is secure,markets are competitive and firms led by people who have proven their merit,capitalism is unique. It is the first economic system in human history in whichmembership of the elite depends on a high level of economic performance.

As a firm owner, if you fail, you are no longer part of the club. Nobody kicks you out,because that is not necessary: you simply go bankrupt. An important feature of thediscipline of the market—produce good products cheap or fail—is that it where itworks well it is automatic; having a friend in power somewhere is no guarantee thatyou could remain in business. The same discipline applies to firms and to individualsin firms: losers lose. Market competition provides a mechanism for weeding outthose who underperform.

Think of how different this is from other economic systems. A feudal lord whomanaged his estate poorly was just a shabby lord. But the owner of a firm that couldnot produce goods that people would buy, at prices that more than covered the cost,as we have seen is bankrupt—and a bankrupt owner is an ex-owner.

Of course, if they are initially very wealthy or very well connected politically, ownersand managers of capitalist firms survive, and firms too stay in business despite theirfailures, sometimes for long periods or even over generations. Losers sometimessurvive. But there are no guarantees: staying ahead of the competition meansconstantly innovating.

Political conditions

Government is also important. The policies it adopts often determine whether privateproperty is secure, markets competitive, and firm leadership is based on merit. Andthese conditions determine how the carrots and sticks of the competitive processwork.

For innovators to take the risk of introducing a new product or production process,their ownership of the resulting profits must be protected from theft by a well-functioning legal system. Governments also adjudicate disputes over ownership andenforce the property rights necessary for markets to work.

But, as Adam Smith warned, by creating monopolies such as the East India Company,governments may also take the teeth out of competition. If a large firm is able toestablish a monopoly by excluding all competitors or a group of firms is able tocollude to keep the price high, the incentives for innovation and the discipline ofprospective failure will be dulled. The same is true in modern economies when somebanks or other firms are considered to be too big to fail and instead are bailed out bygovernments when they might otherwise have failed.

In addition to providing an environment that supports the institutions of the

capitalist economic system, the government provides essential goods and servicessuch as physical infrastructure, education and national defence.


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In a nutshell, capitalism can be a dynamic economic system when it combines:

• Private incentives for cost reducing innovation deriving from market competitionand secure private property .

• Firms led by those with proven ability to produce goods at low cost.• Public policy supporting these conditions, and supplying other essential goods and

services.

These are the three conditions that together make up what we term the capitalistrevolution that, first in Britain and then in some other economies, transformedthe way that people interact with each other and with nature in producing theirlivelihoods.

1.11 VARIETIES OF CAPITALISM: DIVERGENCE AMONG LATECOMERS

Not every capitalist country is the kind of economic success story exemplified inFigure 1.1a by Britain, later Japan, and the other countries that caught up. Figure1.12 tracks the fortunes of a selection of countries across the world during the 20thcentury. It shows for example that in Africa the success of Botswana in achieving

sustained growth contrasts sharply with Nigeria’s relative failure. Both are richin natural resources (diamonds in Botswana, oil in Nigeria) and differences inthe quality of their institutions—the extent of corruption and misdirection ofgovernment funds, for example—may help explain their contrasting trajectories.

The star performer in Figure 1.12 is South Korea. In 1950 its GDP per capita wasthe same as Nigeria’s; in 2013 it was 10 times richer by this measure. South Korea’stakeoff occurred under institutions and policies sharply different from thoseprevailing in Britain in the 18th and 19th centuries. The most important difference isthat the government of South Korea (along with a few very large corporations) played

a leading role in directing the process of development, explicitly promoting someindustries, requiring firms to compete in foreign markets and also providing highquality education for its workforce. The term developmental state has been appliedto the leading role of the South Korean government in its economic takeoff and nowrefers to any government playing this part in the economy. Japan and China are otherexamples of developmental states.


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Figure 1.12 Divergence of GDP per capita among latecomers to the capitalist revolution(1928-2013).

Source: Bolt, Jutta, and Jan Juiten van Zanden. 2013. ‘The First Update of the Maddison Project Re-EstimatingGrowth Before 1820.’ Maddison-Project Working Paper WP-4, January.

From Figure 1.12 we also see that in 1928, when the Soviet Union’s first five-yeareconomic plan was introduced, GDP per capita was one-tenth of the level inArgentina, similar to Brazil, and considerably higher than in South Korea. Centralplanning in the Soviet Union produced steady but unspectacular growth for nearly50 years. GDP per capita in the Soviet Union outstripped Brazil by a wide margin andeven overtook Argentina briefly just before Communist party rule there ended in1990.

The contrast between West and East Germany demonstrates that one reason centralplanning was abandoned as an economic system was its failure, in the last quarter ofthe 20th century, to deliver the improvements in living standards achieved by somecapitalist economies. Yet the varieties of capitalism that replaced central planningin the countries that had once made up the Soviet Union did not work so well either.This is evident from the pronounced dip in GDP per capita for the ex-Soviet Unionafter 1990, shown in Figure 1.12.

The lagging performances of some capitalist economies, including the ones in Figure1.12 in which growth was slow or uneven, highlight the following problems from theright-hand column of Figure 1.11:

• Private property may not be secure as a result of weak enforcement of the rule of lawand of contracts, or expropriation either by criminal elements or by governmentbodies.

• Markets may not be competitive and may fail to offer the carrots and wield the sticksthat make a capitalist economy dynamic.


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• Partly as a result of these failures, firms may be owned and managed by people whosurvive because of their connections to government or their privileged birth ratherthan their aptitude for delivering high quality goods and services at a competitiveprice.

Combinations of failures of the three basic institutions of capitalism mean thatindividuals and groups often have more to gain by spending time and resources inlobbying, criminal activity, and other ways of seeking to shift the distribution ofincome in their favour, and less in the creation of wealth.

1.12 VARIETIES OF CAPITALISM: GOVERNMENT AND THE ECONOMY

We have seen that in some economies—South Korea for example—governments haveplayed a leading role in the capitalist revolution. But even where government’s role ismore limited, as in Britain at the time of its takeoff, governments establish, enforceand change the laws and regulations that influence how the economy works. Forexample, markets, private property and firms are all regulated by laws and policies.Moreover, in virtually every modern capitalist economy, governments are a large partof the economy, accounting in some for more than half of the economy’s GDP.

In subsequent units we investigate why government policies in such areas assustaining competition, taxing and subsidising to protect the environment,influencing the distribution of income, the creation of wealth, and the level ofemployment and inflation may make good economic sense.

One of the reasons why capitalism comes in so many forms is that over the course ofhistory and today, capitalist economies have coexisted with many political systems.A political system such as democracy determines how governments will be selected,and how those governments will make and implement decisions that affect the

population.Capitalism emerged in Britain, the Netherlands, and in most of today’s high-incomecountries long before democracy. In no country were most adults eligible to voteprior to the end of the 19th century (New Zealand was the first). Even in the recentpast, capitalism has coexisted with undemocratic forms of rule, as in Chile from 1973-90, in Brazil from 1964-85, and in Japan until 1945. Contemporary China has a variantof the capitalist economic system, but its system of government is not a democracyby our definition. In most countries today, however, capitalism and democracycoexist, each system influencing how the other works.


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Like capitalism, democracy comes in manyforms. In some, the head of state is electeddirectly by the voters; in others it is an electedbody, such as a parliament, that elects the headof state. In some democracies there are strictlimits on the ways in which individuals caninfluence elections or public policy throughtheir financial contributions; in othersprivate money has great influence throughcontributions to electoral campaigns, lobbying,and even illicit contributions, such as bribery.

These differences even among democraciesare part of the explanation of why thegovernment’s importance in the capitalisteconomy differs so much among nations. InFigure 1.13 we show one measure of the size ofgovernment relative to the entire economy: thetotal amount of taxes collected by government(both local and national) as a fraction of GDP. Even among economies at about thesame level of GDP per capita, the size of government by this measure varies. In the USit is one-third; in six rich countries in northern Europe, it is more than a half.

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Figure 1.13 The size of government as measured by total tax revenue as a fraction of GDP(2012).

Source: OECD (2015), General government revenue indicator.

DEMOCRACY

Democracy is one amongmany political systems,defined by:

• Individual rightsincluding freedom ofspeech, assembly, andthe press

• Fair elections in whichvirtually all adults areeligible to vote

• ... a

Core Econ Unit 1

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Transcript of Core Econ Unit 1